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By johannesclimacus
September 7, 2006

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Here is another stab at valuing Berkshire. Buffett says split it in four groups, so I am going to do that. After all, the vast majority of the investments that I counted separately in my first valuation reside in the insurance operations, presumable to meet statutory surplus desires and risk based capital requirements. So that this discussion is not entirely a repeat, I am going to make some assumptions about what the IV will be at year-end given recent data like quarterly reports, articles, and current events.

Here is the outline for how I think things will look:

By year end, share price IV range is 120K to 162 K, probably more.

1. The insurance operation will be worth about 119 to 148 billion.

2. The value of the energy business will be 14 to 17 billion

3. The value of manufacturing services and retailing 45 to 80 billion

4. The value of Finance and Financial products 7 to 8.4 billion

Range of IV 185 to 250 billion

Shares outstanding 1.54 million: share price IV range is 120K to 162 K

Reasoning piecewise:

1. Insurance operations:
As of the second quarter of this year (p 24), there were about 113 billion total investments in the insurance operations. There were 51.7 billion in equities and 26.6 billion in fixed maturity. An interesting side note is that there are now over eight billion in foreign fixed income. If you think about the foreign bond component and Iscar, as well as other foreign sources of revenue, you will realize that a hedge against further dollar declines is well intact at Berkshire despite the unwinding of currency contracts.

So we have 113 billion in the insurance operations.

Anyway, the total value of the float has not risen that much in the first 6 months. It was 49.5 billion at the end of last quarter. The main reason the float has not grown much is that property casualty premium rates have softened and premiums written are down in most markets (Markel said the same thing). That is going to happen and you WANT to see underwriting decline when rates are not good. The big exception was that BHRG has increased underwriting by over 110% from a year ago because of "improved rates in the U.S. and limited industry capacity for catastrophe reinsurance which led to more opportunities to write new business." The fact that underwriting could slump substantially in many insurance businesses but be increased in another is one of the things that makes Berkshire so powerful as an insurer. It is disciplined, diversified, and hugely capitalized.

I think it is safe to assume that the float will be 50 billion by year-end and that it will still be costless and growing by an annual rate of at least 3% over time (see a "critical look at assumptions" for the reasoning). I also think it is safe to assume that Mr. Buffett will get an after tax return of 2% over the ten year on his investments. While I will not apply this assumption to all of the investments, I will apply it to the float pool in this valuation, however. If you feel uncomfortable about that assumption given compression of risk premia and the huge amount of bonds and cash, then just think of the cash and bonds as being valued at market and the equity investments as comprising the float pool. After all, it is not crazy to think that a dollar of cost free float in Warren Buffett's hands is worth more than a dollar in a regular investor's hands. Time has proven this to be fact before, and as markets swing back to normal risk/reward levels, time will prove it again. Buffett is known to be one of the most patient investors ever. He can wait for opportunities and opportunities will come eventually. If you don't feel ok about that, then perhaps you will feel that boosting float returns with a slight underwriting profit of 1% annually will offset your concerns about investment returns. After all, it is looking like the insurance businesses could get a 2.8% underwriting profit this year, barring another Katrina.

So assuming a 9% discount rate, 10 year is 4.78%

PV of cash flows:

[50 * .0678 * (1.03/1.09)]/[1-(1.03/1.09)]= 58.2 billion_

So assuming a 7% discount rate, and a 10 year of 4.78%= 1.03/1.09

[50* .0678 * (1.03/1.07)]/[1-(1.03/1.07)] = 87.3 billion

The range of the float value is 58 billion to 87.3 billion. The investments in the insurance business are 113. Subtract the float pool of 50 billion, which we just valued. Subtract 2.64 billion in debt that could possibly be in the insurance companies (page 11).

60.4 billion in assets

Note: I decided to throw out deferred taxes (which totaled 15.8 billion on June 30th) as a charge against investment value because I made tax assumptions for the float pool and I don't think management views deferred taxes as a liability given its buy and hold strategy. We know that Buffett views Berkshire's float as equity because it has the property of perpetually sitting there at no cost while gaining returns for Berkshire on the assets. Why would this not true for deferred taxes as well? Warren Buffett 2005:

"Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have
grown rapidly and now total about $60 billion." (AR p 75)

All right range of value for the insurance operations:

118.6 to 147.7

For people who find this hard to believe, all I can say is that Buffett views float as equity at Berkshire and he views deferred taxes in a similar light. It is not crazy to think that the value of Berkshire insurance operations could be equal to the value of the assets on hand or could be even better than the value of the assets on hand, given that Buffett's investment acumen usually gives above average returns on assets and Berkshire's underwriting discipline usually spews out profits!

2. Energy and Utility

As of Q2, The Energy and Utility business are probably earning over 800 million after tax as I predicted in the first valuation. For the first 6 months of 2006, energy earned 391 million after tax. The reason why it will likely be over 800 million this year has to do with the seasonal nature of the energy business . . .

"Revenues and earnings of the utilities and energy businesses are, to some extent, seasonal depending on weather-
induced demand. Revenues from electricity sales can be higher in the June-September period and revenues from gas sales
and pipelines can be greater in the November-March period. Real estate brokerage revenues tend to be greater in the
second and third quarters."

So the range of value for this group at year-end based on comparable PEs for other utility businesses is

800 * 17 = 13600

800 * 20 = 16000

This number is conservative if you think about what is in store at Mid American Energy. Buffett bought this so that he would have a place to make large bolt-on acquisitions, AS WELL as an opportunity to make large internal investments with the cheap capital he generates in other parts of Berkshire. Even if Mid American were to not make another bolt on this year, it is making 2.4 BILLION in capital expenditures. WOW. "Forecasted capital expenditures, construction and other development costs for the year ending December 31, 2006 are approximately $2.4 billion. Capital expenditure needs are reviewed regularly by management and may change significantly as a result of such reviews." (page 29 Q2) My guess is that these capital expenditures will greatly increase Mid American's earning power in the near future. We shall see. The wind power project last year proposed last year sounded interesting and profitable.

3. Manufacturing Service and Retail.

This group put up 932 million in after tax profits in the first 6 months of 06. If you double that figure, you get 1864 for the year.

BUT, that is before the addition of Russell and Iscar. The second quarter report warned vigorously that Iscar operates in a dangerous environment in the Middle East. That warning, though not explicit, had to do with the recent war in Lebanon. I think this warning is way over blown. I have not read about any damage to Iscar's business from that war. If anything, war stimulates industrial production and the businesses involved with industrial production. Sadly, just like the tragedy in Iraq has been a stimulant to US business, the war in Lebanon likely HELPED Iscar's business. (War is a political tool for stimulating an economy. The stimulus is real but wealth is often just diverted from the average man toward the owners and suppliers of large military or industrial businesses.

DeToqueville observed about democracies that it is difficult to get them to go to war and to stay at war. One way people at home start to feel bad abut war is when their taxes increase. So what do politicians do who want to sell a war? They happily cut taxes and issuing debt to finance war activities, leaving the burden to future generations. Seems like a free lunch. Some countries can find no buyers for their debt, so they simple print money to pay for their costs, which creates inflation. Our country issues debt and when it is not politically opportune to ask the populace for higher taxes to pay off the debt, the debt is monetized by the federal reserve, generally through open market operations. That is, money is printed. And money is often printed by the central bank in excess of real economic growth, which creates inflation and havoc. People wonder how with such good economic activity so many people have slipped into poverty in America in recent years. The answer is inflation. Not what the government reports as inflation, but what is actually happening to purchasing power. Buffett quipped at the AM that he does not know what is more "core" to the average consumer's purchasing power than food and energy costs, which are excluded from "core" inflation numbers. If the cost of eating, transportation, housing, and health care has been rising quickly, which it has, then inflation is already here and hurting the most basic element of American society.

As the average consumer goes tapped out on credit and loses purchasing power, so will go the economy. The pain and inflating will be here to a much larger extent in the future as we deal with double whammy of entitlement burdens and the exporting of American wealth to foreign owners of our production. And political central bankers will probably still be telling everyone that inflation is not bad and that they want a STRONG dollar, when the reality is that neither statement is true. I personally wish people had listened to Milton Friedman when he argued against managing economic activity with the money supply. What I really wish is that we had the semi-sadistic, sober Volker in the chair. He did not seem to give a damn about being popular or about playing politics. Greenspan bubble vision and the huge amount of capital chasing imprudent investments would not be here today if we had had the unpopular Volker for FED chief instead of Greenspan. But none of this really matters. The more the Fed uses money supply/interest rates to manage the economy, the worse the fallout will eventually be, according to Hyman Mynsky. And the opportunities will eventually rain down for Berkshire and anyone else who has a lot of cash money. That is, if there has not been a tremendous out-pouring of foreign money from dollar denominated assets. Anyway you look at it, an additional screw job for the average joe, who probably has his life saving in some Putnam blended mutual fund and will be rioting in a lovely neighborhood near you someday ; - )

That said, how has Iscar performed in years past? It was privately held, but from what I have read it has pounded out money. According to the Financial Times, my favorite paper, Sever Plotzker of daily Yedioth Aharonoth estimated Iscar's net annual profits to be between 300 and 400 million over the last couple of years. I think that Iscar will return after tax profits of 400 million to Berkshire's ownership in Iscar, and that would be in line with the average of 10 percent return on carrying value for this group of businesses. One might ask how we could get that kind of deal? The average Israeli company was trading at about 8X earnings when we bought it, according to Financial Times international stock tables that I read at the time!

As for Russell, we paid 600 million. Last year Russell had after tax returns of 34 million, BUT Berkshire is also paying off 520 million of term debt and revolving credit loans. The repayment of those debts will flow directly to the bottom line for Russell. I think Russell will easily be producing after tax profits of over 60 million going forward after the debt is repaid. . .

So, the earning power for this group will be about 2324 (1864 + 460) million by year-end. AND this does not even account for what Berkowitz calls the hidden earning power of some of Berkshire's businesses. Right now Buffett loves to allocate capital to businesses in this group when they need it for good reasons. Some of that investment is capitalized on the balance sheet like the recent huge spend in flight services, but some of the investment is EXPENSED. . . Berkowitz, "If they ever took the pedal off the metal of some of the businesses they're investing in, like NetJets and GEICO, you'd see the operating earnings jump significantly. They spent $500 million--more than $300 per share--just in GEICO advertising last year".

So what does this mean? The manufacturing sales and retail is very valuable.

In my last valuation I kind of eyeballed the "business segment data" from the footnote section of the annual to get a sense of owner earnings. The big hit to owner earnings was the massive capital investment in flight service, so I just assumed it was a somewhat more "normal year' for flight services and went from there.

Here is a slightly different analysis for the group but perhaps more rigorous.

Owner earnings analysis:

This all comes from the published business segment data in the annual reports. In the year 2000 and before, Berkshire does not disaggregate Finance and Financial Products in business segment data. "This group of businesses also includes several
independently operated finance and financial products businesses." (P 42, 2000 AR). So it does not make sense to look at the manufacturing sales and retail group as distinct beyond that point if the data is no longer available.

The categories
net, deprec, capex, owner earn, owner earn as a percent of net .
2005- 1664, 699, 1781, 582, .35
2004- 1540, 676, 853, 1363, .89
2003-1344, 605, 718, 1231, .92
2002- 1198, 477, 574, 1102, .92
2001-(1401 pretax ) 869, 395,748, 516, .59
2001* (1587 PT) 984, 402, 753, 633, .64

There was a peculiar downwards restatement of data for the 2001 year . . . that is why there are two sets of data for 2001; but it seems reasonable to think that owner earnings will run about 75% of net income on any given year:

I already estimated earning power for this group at 2324 million for year-end (and that excludes hidden earning power that Berkowitz refers to)

If owner earnings run about .75 of net, then the owner earning power is about 1743.

Assume growth is dangerous, as Hartman Birge has rightly pointed out in the brief time I have been reading this board. So I decided to bring the growth rate assumption down. Even a savings account will grow returns over time, and I think it is safe to assume that a hand picked group of businesses by Warren Buffett with economics from good to great will probably grow owner earnings internally at a rate of 7% for 10 years and then level off at a rate slightly above government reported inflation (which is complete bullshit) inflation of 4 %.

So the range of value for this group assuming a discount rate between 7% and 9%

Stage one for 9% discount
1711 [1 � (1.07/1.09)^10]/[1- (1.07/1.09)] = 15764

Stage two for 9% discount
pv of cash flow 11 is 1357, so the residual value

1357 / [1- (1.04/1.09)]= 29583

PV of owner earnings at a 9% discount rate is 45347

Stage one for 7% discount


Stage two for 7%

PV of 11th owner earning is 1694

1694/ [1- (1.04/1.07)] = 60424

Present value of owner earnings at a 7% discount rate is 77, 854

Range of value is 45347 to 77854.

4 . Finance and Financial products

OK I am tired of reading and writing now. It looks like Finance and Finance and financial products is on track to earn over 700 million after tax this year. Because it is volatile and capital intensive, I think an after-tax PE of 10 to 12 would be reasonable.

Range of value: 7 billion to 8.4 billion

In the AR, Buffett posed the following question. "Of course, the value of Berkshire may be either greater or less than
the sum of these four parts. The outcome depends on whether our many units function better or worse by
being part of a larger enterprise and whether capital allocation improves or deteriorates when it is under the
direction of a holding company"

The question is a joke. I have Berkshire worth about 120 to 160K a share, but I think it is worth 135 to 175 a share, because I think the capital allocation skill at Berkshire will likely slaughter any and all assumption I have made.

The structure of Berkshire Hathaway is the most rational and exciting part of the business. You have the smartest, most conservative and patient capital allocators in Buffett, Munger, and Simpson. They can deploy massive amounts of capital anywhere in the world. There need be no meetings with morons. They need not worry about getting wealthy or losing their jobs. All they have to do is be patient and wait for the right opportunities. Sometimes like right now they get one or two a year. Sometimes, and those time will come again, the opportunities rain down like water and their problem will be trying to focus in on which idea is better. Buffett, Munger, and Simpson will allocate capital intelligently and beat a risk free discount rate now and for many years to come.

Mason Hawkins said in the last edition of OID:

"When we do our appraisals, we project out the free
cash flows will generate, put a terminal multiple on it
about 8 years out, and bring it back to the present by
discounting those cash flows at an appropriate
discount rate. And our discount rates are very
conservative- something on the order of 9%. Thus the
implicit assumption we're making in order for our
appraisals to be absolutely accurate is that every
coupon gets reinvested at 9% . . . if a board gives us
the money, the dividends - either in a direct payment
or through direct share repurchases - and we can put a
dividend repayment back to work at more than 9%, then
our appraisal's going to be conservative . . .It
speaks to why Berkshire can pay full price for a brick
company or a rug company. . ."

I have nothing to add to this.

Best regards,
John Climber

A few questions from Anti-climacus:

AC: If you assumed the earning power of Iscar and Russell in your valuation, should you not deduct the purchase price from the investments and cash?

JC: No not really. This is a projection valuation. Net earnings were about 4660 in the first half of the year. When Russell and Iscar are added to the mix, the retained earnings from the second half of the year will likely be just about the size of the Russell and Iscar purchase.

AC: What if you are way wrong about Iscar's net income.

JC. Not likely. But you can make up the difference in the hidden earning power that Berkowitz mentions.

AC: You really think the US is headed for a big fallout and that investment opportunities will soon more than reward Buffett's patience and the patience of anyone who can sit on cash for extended periods of time?

JC: Yes. If I'm wrong, Berkshire is still safe and cheap. If I'm right, then it will be an even better investment.

AC: What will be the catalyst for convergence to IV?

JC: Knowledge. That is why I am doing this. If and when owners of Berkshire realize that it is far more valuable than it trades for in the market, the share-price will climb substantially and we can go back to Alaska soon. I know I won't sell my shares at anywhere near today's market prices.

AC. Hope so. This is really long and boring.

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